HELOCs: Will weather be better than the forecast?

For some time now regulators and analysts have been expressing concern about billions of pre-recession home equity lines of credit—HELOCs—nearing their “end of draw” period. While typically borrowers could make only interest payments during the draw period, the time when they could transact from their accounts, once the end of draw occurs, they must make payments of both interest and principle, to amortize the loan. Payment shock is a concern, as is the corollary concern that in many markets current home values will not support rollover of the credit into a first mortgage or otherwise, to retire the HELOC.

TransUnion Inc. has unveiled research that puts this risk in a new light.

“The risk is both broader and narrower,” says Ezra Becker, co-author of the study and vice-president of research and consulting for TransUnion, in an interview.

Broader, says Becker, in the sense that it must be examined in light of HELOC borrower’s other indebtedness—they rarely only have HELOC obligations, also having credit card, auto loan, and other credit to pay off. Becker explains that some borrowers may pay their HELOCs and not pay other debts, for example.

Narrower, Becker continues, in the sense that many HELOC borrowers may be more able to handle payment shock than some believe. This is not to say that there won’t be some consumers heading into trouble—only that not all HELOC borrowers are going to be in hot water.

Nor does Becker think there should be any surprises for lenders who have their act together, nor for consumers who look ahead and address how significantly their monthly payments will rise once amortization begins.

Those whose homes have retained or regained value enjoy an advantage others will lack. “If you have equity in the home, you will have more options,” says Becker. “But if your home is still underwater, it will be hard to do anything.”

Essentials of TransUnion’s case

The credit reporting and analysis company’s argument is that there is much data in credit files and bank files available by which to identify those customers who will be in the pockets of a HELOC lender’s portfolio that will be challenged or even severely troubled by the time the end-of-draw period commences. TransUnion believes that the greatest risk of default involves less than 20% of balances.

The company says there are nearly 16 million American consumers holding approximately $474 billion in HELOC balances, as of yearend 2013—$438 billion of which had not hit end of draw yet.

Many borrowers have HELOC balances exceeding $100,000. The company estimates that $50 billion to $79 billion of those balances could be at “elevated risk” over the next few years. Nearly half of the outstanding lines were originated between 2005 and 2007, and they frequently had ten-year draw periods—hence, they will be nearing end-of-draw soon.

TransUnion’s study evaluated a large sample of loans and drew conclusions about the HELOC universe from that analysis. Some key conclusions:

• Capacity to absorb payment shock is important. Some borrowers have it. For example, some consumers may have already been making excess payments on their HELOCs. Those payments, used to retire principal early, will now be available for the required amortizing payments.

• About 40% of the outstanding balances belong to borrowers with very little capacity to absorb payment shock. Likewise, about 29% of the balances are held by borrowers who don’t have viable options for existing the loan, such as by selling the house.

• However, the data in the previous point indicates that many other HELOC borrowers may have viable options or the ability to handle payments at some level.

• The two groups in question—the 40% and 29%—break down further by credit score and current excess payments. At the end of the day, TransUnion believes that between 11%-19% of balances will be at risk.

This has been a high-level view of TransUnion’s arguments. To walk through a PowerPoint on the company’s research, including some decision-tree style logic, click here for Understanding HELOCs: Facts Versus Fear. (The link will take you to an infographic, which includes a registration point for an instant download of the file.)

The document detailed the risks involved and how examiners will be looking at how institutions manage the risk of end of draw, including how prudently their underwrite modifications of existing HELOCs. In addition, they will be monitoring how appropriately loans are classified as the borrowers’ performance becomes clear. Expectations for treatment of troubled HELOCs under troubled debt restructuring accounting rules is also addressed.

The Office of the Comptroller of the Currency has been alerting banks to the need to watch HELOCs nearing the end-of-draw period, in examinations and through such communications channels as the agency’s Semiannual Risk Perspective.

The agency declined to specifically address the TransUnion research, but agreed to provide an update on OCC’s perspective on banks’ handling of the end-of-draw issue, through an interview with Darrin Benhart, deputy comptroller for credit and market risk.

Benhart noted that the agency has been working closely with its larger banks, which represent the majority of the national bank HELOC activity, including a “horizontal review”—a focused examination, essentially—that helped provide some of the meat behind the interagency guidance. Benhart said there were no surprises for larger institutions in the document, and that it was aimed especially at smaller institutions that needed to look into end-of-draw issues.

However, Benhart said that the sheer dollar volume of HELOCs expected to enter the end-of-draw phase in 2015, 2016, and 2017 could still present challenges to the lending industry. He said this could especially be the case if a slowdown developed in the nation’s housing sector. While there’s been much improvement in residential property prices, he pointed out, only in a few markets have prices returned to pre-recession levels.

“The thing that’s difficult to get a good handle on is people’s ability to meet a stepped-up amortizing payment,” said Benhart. Even with the several payment models that are available in the industry, he said, it can be a challenge figuring a customer’s ability to repay once the amortization period kicks in.

Benhart said that many larger banks have been proactive in identifying exposures in the HELOC area. He said a typical response to loans entering end-of-draw has been to roll the balances into an amortizing first mortgage, where the borrower will qualify. He also acknowledged that banks are making new HELOCs, and pointed to a new variation being offered by Wells Fargo. The bank’s new HELOC product has an amortizing payment built into it, in lieu of the traditional interest-only policy during the draw period.

While some observers have pointed to falling delinquency rates in HELOCs, Benhart cautioned against taking these numbers at face value. He pointed out that delinquencies on vintage HELOCs remains at higher levels, while delinquencies on newer HELOCs tends of be lower, more like first mortgages. He said the two trends together come out to a stable delinquency level, but that it was important to understand how both loan categories were behaving, separately. The newer loans, he pointed out, are not near their end-of-draw point.